Managing payroll is no simple process. There are several different steps and responsibilities that you need to address, all of which make managing payroll for a small business both time-consuming and difficult. Of course, that process becomes even more stressful when the IRS comes knocking.
While the overall odds of an IRS audit for a small business is low, there are certain factors that can greatly increase the chances that your organization is targeted. The IRS looks for a variety of red flags to identify taxpayers and businesses that are more likely to have inconsistencies in their taxes. Here are nine small business IRS audit triggers that may increase your odds of an inspection in the future.
Consistently Filing Payroll Taxes Late
Late payroll tax filings can lead to more than just penalties. Regularly missing filing deadlines is a surefire way to get your small business on the IRS’ radar. It’s in your best interest to try and file your taxes in a timely manner, even if that means you’ll need a head start to get them done. Remember, it’s better to get ahead of schedule than deal with IRS headaches in the future.
Failure to Report Taxable Income
Late filings are one thing, complete failure is another. A failure to report your payroll taxes is just about the biggest red flag of all for the IRS.
Not reporting your own personal income is also another warning sign. The IRS wants to ensure that you aren’t withholding income in your calculations. If you fail to report payroll taxes or personal income, you should expect to hear from the agency at some point.
Reporting Net Losses in Multiple Years
If your business has reported net losses in three or more of the past five years of operation, the IRS may want a closer look at your books. The IRS typically assumes operations that show a profit in at least three out of five years are legitimate companies. As such, the IRS may view businesses with multiple net losses in recent years as a potential offender of hobby loss rules.
In short, the IRS wants to identify if your business has “an actual and honest profit motive” and not just a hobby that’s abusing tax deductions. The problem is that these hobby loss rules can disallow certain deductions that may have saved you money. As such, you’ll want to make sure that any deductions you claim for your business are supported with the appropriate receipts and documentation.
Too Many Deductions
Claiming tax deductions available to your small business is one of the simplest ways to reduce your income tax bill. However, claiming too many deductions can put you and your small business at greater risk for an IRS tax audit.
It’s important to be careful when you choose your deductions as a small business owner. The general rule of thumb for the IRS is that your expenses should be considered “ordinary and necessary” for your line of business. If you think that a meal, stop for gas, or travel expense pushes the boundaries of ordinary and necessary, it may be safest to not make a claim. This is especially true for sole proprietors, as they are at greater risk for audits than other small business owners.
Another potential red flag for the IRS is if you suddenly claim more deductions than you had in past years. The IRS may see a sudden increase in deductions as suspicious and may audit you to make sure this new trend is by the books. To avoid this from happening, compare your deductions from recent years to make sure you’re consistent with your deductions.
Excessive Claims of Business Use for a Vehicle
Car expenses can be typical for many business owners – the IRS even publishes standard mileage rates for businesses each year. However, the IRS is quick to scrutinize whenever someone claims 100 percent business use of a vehicle. If you do, you’ll want to carefully document not only your vehicle expenses, but also the purpose of your various trips. The IRS will want to know whether your business vehicle was used for legitimate business-related activities and not personal commuting expenses like driving to your office from home.
Another potential red flag for the IRS is if you deduct expenses in multiple ways. The IRS allows you to determine deductible car expenses through the standard mileage rate or actual expense methods such as fuel, repairs, and general upkeep. While you can choose between the two deduction methods, you cannot use both in the same year. If you do, the IRS may come calling about your business deductions.
Net Operating Loss Carrybacks or Carry-Forwards
It’s not uncommon for small businesses to carry forward net operating losses to reduce a company's future tax liability. In fact, the CARES Act amended rules to allow “for a carryback of any net operating loss (NOL) arising in a taxable year beginning after Dec. 31, 2017, and before Jan. 1, 2021.” As such, small business owners have some additional flexibility to account for net operating losses.
While these carrybacks and carryforwards are allowed, they can increase the odds of an IRS audit. The IRS will want to make sure that these transactions are up to agency standards and that everything is conducted legally. Make sure to properly document any such carrybacks or carry-forwards to make sure your business is in the clear in the case of an IRS audit.
Giving Large Sums to Charity
Donations are a great way to support important causes and help people in need. Unfortunately, the IRS adopts a more skeptical view of small businesses giving to charity. If your business suddenly increases the amount of money donated in a year, the IRS may want to make sure that these donations aren’t an attempt to abuse the tax code.
One way to avoid IRS scrutiny is to maintain a steady level of donations each year. By slowly scaling up your charity efforts, the IRS will have less reason to find your donations as a suspicious way to avoid paying small business taxes.
Businesses that deal mostly in cash transactions are naturally bigger targets for the IRS. The explanation for this is because it’s much more difficult to verify cash income. Because of this reason, your small business may simply be more prone to IRS audits if you regularly process cash transactions.
Large cash transactions are another sign that can trigger an audit. Purchasing new business equipment, company vehicles, or other investments with cash will potentially draw agency attention. If you can, try to pay for these business expenses using credit or debit cards to avoid IRS scrutiny.
If you prefer cash, just make sure to maintain detailed records of cash transactions to help in the case of an audit. You can also complete IRS Form 8300 for any receipts exceeding $10,000 within the U.S.
Rounded Numbers and Calculation Errors
Sometimes simple mistakes can lead to IRS scrutiny. As you may expect, mistakes on your tax filings are going to attract IRS attention. However, you may not realize that you’re making a mistake when you do the math.
One common issue with tax returns occurs when small businesses use rounded numbers. While rounded numbers may seem convenient, the IRS will get involved if they see that a business isn’t using exact numbers to denote earnings and expenses for tax purposes. The best way to be safe from this red flag is to avoid average and round numbers and always work in decimal points unless otherwise specified in your tax filings.
Protect Your Small Business from IRS Penalties and Other Dangers
Filing payroll taxes is no simple process. Not only is the filing process complex, the rules regularly change from year to year to make it an even more confusing task. Fortunately, you don’t need to let payroll tax management take up too much of your busy schedule.
When you need to free yourself from the struggles of payroll tax management, GMS can help. Our experts can not only save you valuable time, we can also help you stay up-to-date with ever-changing regulations and avoid costly penalties. Contact GMS today to talk to our team about how we can make your business’ payroll simpler, safer, and stronger.